European and US bonds rallied as the renewed potential for a peace deal in the Middle East drove down oil prices and eased concerns over quickening inflation.
The gains were led by shorter maturities as the fall in energy prices meant traders dialled back bets on interest-rate hikes in the region. UK two-year yields slid 14 basis points to 4.20% and their German peers dropped nearly 10 basis points to 2.58%, while US Treasuries saw more muted moves.
The rally follows a sharp reversal in rhetoric from US President Donald Trump, who said on Thursday that a deal with Iran is close after earlier threatening fresh military strikes and to seize the country’s oil infrastructure. It’s the latest in a series of about-turns driving the market.
“European government bonds are reacting to the more optimistic headlines we are getting. Oil is continuing its freefall and that is driving a rally,” said Evelyne Gomez-Liechti, a multi-asset strategist at Mizuho International Plc. “It’s rational for the market to price in some optimism on a resolution.”
Traders have now pared bets on further European Central Bank rate increases for the rest of this year, after policymakers countered the inflationary impact of the war by lifting the deposit rate on Thursday by 25 basis points. Money markets have also cut the chances of multiple Bank of England rate hikes before the end of the year.
The BOE will decide policy next week but markets are now only pricing in a single hike by November. While the ECB’s President Christine Lagarde warned on Thursday that inflation is widening beyond energy, she said the bank wasn’t pre-committing to any rate path.
“The ECB yesterday was less hawkish than market fears,” said Daniel Loughney, head of fixed income at Mediolanum International Funds. He also pointed to a potential Iran deal and weak UK growth figures on Friday, saying he was “not surprised to see the big rally” and “a bit of sense” was coming back to markets.
That view is keeping him long on duration in both gilts and Treasury markets, while he added to positions in two-year German government bonds last week.
The US and Iran are edging closer to signing an agreement to reopen key shipping route the Strait of Hormuz, according to senior officials, with the Group of Seven world leaders set to meet next week. Brent crude futures fell to below $86 a barrel for the first time in three months.
Read more: US and Iran Nearing a Peace Deal Around G7 Meeting Next Week
The limited reaction in US Treasury yields followed a bigger drop there late Thursday, with two-year yields only down two basis points Friday to 4.05%. Not all strategists are convinced on further bond gains from here, with Natixis SA’s Benoit Gerard recommending fading the rally.
UK Risks
“Gilts have just traded with a higher beta to oil in the current environment,” said Megum Muhic, a strategist at RBC. “In my opinion, risks going into next week are that there will be a disappointment on this peace deal and UK political risks will come back to the fore. I wouldn’t want to be chasing this gilt outperformance move here.”
Next Thursday, a local election in the UK could propel Labour candidate Andy Burnham to parliament, where he would be likely to challenge Prime Minister Keir Starmer for the top job, spelling huge uncertainty for gilts . Little is known about his plans for the country’s finances were he to take over at 10 Downing Street, with the market paying close attention to any comments on his proposed fiscal policies.